The post-subprime regulation scramble: the regulators and market players pick up the pieces.

• Author: Engelen, Klaus C.

As U.S. President George W. Bush and his Treasury Secretary Henry Paulson were working on a wide-ranging relief package to help struggling homeowners refinance subprime adjustable-rate loans or freeze the current interest rates for five years, some European finance ministers, leading politicians, and top bankers seized on failings exposed by the credit crunch to call for more pan-European supervisory arrangements. Some of them are pursuing the ultimate goal of a super-regulator to oversee EU financial markets.

It was Tommaso Padoa-Schioppa, Italy's finance minister and a former board member of the European Central Bank, who stirred things up. He sent a letter to EU finance ministers calling for a "single rule book that will be enforced uniformly all over the European Union" and for "binding standards" in all EU member states. Having been in charge of prudential supervision at the ECB board, Padoa-Schioppa argued that "the Commission and the European Central Bank had come through the crisis with flying colors, but the supervisors had failed--chiefly because they are scattered across the European Union and answerable only to capitals." In his view, "the recent financial turmoil was a revealing test of the shortcomings of the present system" and "it is now necessary and urgent to act decisively to enhance the European supervisory system." And summing up the failures in EU financial market supervision, he wrote: "It is disappointing that no sharing of confidential information on potential systemic risks to the European financial system appears to have taken place among EU supervisors. In crisis situations, European supervisors can be expected to act based on a narrow national perspective."

Since almost simultaneously EU Economic and Monetary Affairs Commissioner Joaquin Almunia launched a broadside against the present nation-based supervisory system, there was talk at the December EU finance ministers' meeting of a well-coordinated campaign by EU insiders for more Commission authority in financial market supervision. According to Almunia, "Pressure is mounting for European supervisory arrangements. Financial institutions should be subject to essentially the same rules irrespective of where they operate in the Single Market."

As was to be expected, U.K. Chancellor of the Exchequer Alistair Darling and German Finance Minister Peer Steinbruck rejected calls for pan-European regulation of financial markets. The German side argued for improving the working of the prevailing "Lamfalussy Process" for regulation and supervision of EU markets, called after Alexandre Lamfalussy, the Belgian central banker who chaired the committee that devised it ("A Lamfalussy Primer"). The British pointed out that the United Kingdom and Germany accounted for about 55 percent of total wholesale financial services volume in the European Union in 2006, while Italy and France, countries favoring a more centralized system of supervision, only accounted for 8 percent of the market during that period.

From a European point of view, Karel Lannoo, who has worked for years on financial market supervision issues and who manages the Centre for European Policy Studies (CEPS), sums up the situation: "The unfolding financial market crisis is presenting [also] the European Union's regulatory and supervisory system with its first big test." In his view, the crisis "has revealed worrying differences in responses to stress, flaws in the enforcement of rules, and gaps in the supervisory framework." And we share his warning that "central bankers, policymakers, and national banking supervisors urgently need to agree to a set of policy priorities and to prepare a more integrated response to crises. The international reputation of Europe's financial market is at stake."

Nicolas Veron, a research fellow at the Bruegel Institute, argues: "German supervisory setbacks and the Northern Rock debacle have shone a spotlight on crisis management and prevention, and highlighted how different regulatory settings either helped or hindered efficient public policy." According to Veron, in the view of the City of London as a financial hub, "the liquidity crisis has concentrated minds," and has shown how the United Kingdom's interests could be best served by ensuring Europe's financial regulation becomes more efficient and credible rather than, as until now, by "'keeping Brussels at bay' and making sure that none of the continental developments has a material effect on London's practices."

Taking the proper lessons from the recent failures, Europeans should reassess the Lamfalussy Process, says Veron. Thus, the City "should play a leading role in improving Europe-wide financial regulation." This means "to reorganize supervision at the national level, including most conduct-of-business regulation, and to devise adequate ad hoc solutions at the European level for those tasks for which financial integration has rendered the national approach insufficient."

AN AMBITIOUS WASHINGTON REFORM AGENDA

Looking back at annual meetings of the Bretton Woods institutions, financial market regulators and supervisors historically have played a marginal role. But not this time around as the International Monetary Fund and the World Bank held their annual meetings in October in Washington. Under the shadow of the subprime crisis and its global implications, they launched an ambitious reform agenda.

For many observers and market participants the failings in financial supervision--as they became apparent in the U.S. subprime mortgage sector, in the problems of German banks with their off-balance sheet conduits, and with the bank run at the United Kingdom's Northern Rock have contributed to the costly financial crisis, as did too-low interest rates. Therefore, not only market participants--with major financial institutions and their shareholders losing billions of dollars--but also supervisors and regulators are licking their wounds while central banks, reacting decisively in the crisis by providing huge amounts of liquidity, have generally increased their importance and reputation. In some EU countries--such as Germany and the United Kingdom horrendous shortcomings have led market participants and the broader public to question present financial market supervisory arrangements and institutions.

Thus, financial market supervisors and regulators moved to center stage not only in the official discussions of the G7 nations, but also at numerous financial industry gatherings where regulators and supervisors discussed the lessons of the current financial turmoil with top representatives of the private sector.

At the Washington meetings, regulators and supervisors were asked by the G7 finance ministers and central bank governors to work with other authorities to come up with proposals to limit...